CHAPTER 12Portfolio Management Through Time: Taxes and Transaction Costs
Chapter Outline
- 12.1 Introduction
- 12.2 Performance Shortfall
- 12.3 Portfolio Adjustments Without Taxes or Costs
- 12.4 Transaction Costs
- 12.5 Taxation of Investment Returns in the United States
- 12.6 Strategies to Reduce Individual Investor Taxes
- 12.7 Tax Managing a Portfolio of Securities
12.1 INTRODUCTION
Portfolio management is an inherently dynamic process. In Chapter 5 we saw that changing investment opportunities induce dynamic adjustments in our desired, or target, portfolio. For investors with finite lives, the mere passage of time will induce portfolio adjustments due to shortening investment horizons. At an even more basic level, market movements require us to rebalance portfolios to avoid drifting away from our desired positions.
This chapter focuses on two sources of friction—transaction costs and taxes—that affect our ability to keep an actual portfolio aligned with our ideal, target portfolio over time. These factors have both direct and indirect effects on performance. The direct impact is, of course, the drain on assets when the costs are incurred. One indirect impact arises because frictions inhibit fully capturing the potential value added of the ideal portfolio. Another indirect impact is especially important in the case of taxes. Because taxes alter the relative risk–return characteristics of available assets, tax avoidance may induce managers to select portfolios ...